What do companies need to do when they are considering investing in China? Which investment vehicles should they use? How is the investment environment changing? The following should offer some guidance.

Background
Although China has been a target market for exporters for many decades, setting up local companies (often known as foreign-invested enterprises, or FIEs) used to be the preserve of the larger foreign corporations or - amongst SMEs - those with substantial experience of China. In recent years, many smaller companies have come to China not just as exporters but as investors in their own right. China is now more accessible to those who previously found this market difficult and daunting.

The authorities in China, both at a central level and at a local level, are now much familiar with foreign investors' needs and expectations. Many city and industrial zone authorities have become adept at creating a welcoming atmosphere and the conditions that are capable of attracting investors. Some inward investment organisations offer considerable assistance as part of a 'one-stop shop' approach.

Before, foreign investors would always be encouraged to set up joint ventures (preferably favouring local entities as prospective partners). Nowadays, inward investment authorities tend to recognise the efficiency of the wholly foreign-owned enterprise (WFOE) style of investment. International business norms and practice are becoming more prevalent in China, aided by the removal of barriers following China's accession to the World Trade Organisation in 2001.

Why manufacture in China?
There are many reasons for considering China as a manufacturing base. A typical investor will normally be motivated by a combination of factors. The most familiar reason is the reduction of costs by taking advantage of China's low labour rates. Chinese shopfloor wages are frequently quoted at around one-tenth of equivalent UK rates. Taken together with other savings, such as the prospect of significant Bill of Materials reductions, some companies calculate the overall cost of their manufacturing operations in China to be around one-third of comparable operations in the UK.

Access to low-cost raw materials may justify locating production close to their source, rather than incurring the cost of shipping materials half way around the world. Supply to customers in Chinese or Far Eastern markets may mean that a China production base, entailing a short, economical supply chain and ready responsiveness to local demand, can also be attractive.

Political factors may also play a part. Establishing a factory in China may be seen to demonstrate commitment, at a local or even a national level. Or a company may be encouraged to participate in the location philosophy of the Western company it supplies. More and more companies are encouraging their suppliers to join them in establishing production in China.

Is local investment the right decision?
Think before you invest. It is easy to underestimate the final cost of what is still a bureaucratic course of action in a distant and sometimes difficult market.

Careful attention to calculations such as internal rate of return are essential to gauge the true cost of transferring production to China. Be realistic about what can be achieved through setting up production in China. (There is no point in relocating an automated production process to China purely because of the low-wage environment, for instance.)

It will probably be necessary to re-design elements of a product destined for manufacture in China. Although many companies achieve a satisfactory outcome, re-design is a further cost to be borne in mind when transferring production to China.

Outsourced production
When looking at the attractions of manufacturing in China weigh up the benefits of subcontracting, or outsourcing, in China. If your company's manufacturing requirements can be met through an outsourcing operation, this may be the better option. It may be possible to outsource using local manufacturers in China. Much of the myriad of goods on sale in the West bearing a ‘Made in China' label is manufactured under contract.

The problem is that there may be barriers similar to those facing investors: an unfamiliar location with what appears to be an alien business culture. Again, there may be the challenges of re-design work if this is to be a feasible option.

In many cases it will not be possible to deal direct with a small Chinese manufacturer; such entities do not possess the all-important licence to export the finished goods.

Getting an export licence has become much easier than before. But it is still often compliciated by the fact that you have to use a local import/export company to get your products out of China. But it can be organised, and sometimes smaller manufacturers offer low-cost production in conjunction with a local import/export company equipped with such a licence.

Whether one is dealing direct with a local back-street factory or through an import/export company, the quandary for many British companies is how to contract safely with a company of this kind? Will the timescale, quality and price of the production be acceptable? Are the various parties involved honest? And what about the protection of the intellectual property entrusted to the Chinese manufacturer?

Most Western companies outsourcing production to China eventually find solutions and emerge from the process with satisfactory products manufactured at attractive prices. But many experience enormous misunderstandings and difficulties along the way. There are widespread accounts of problems in achieving quality standards, in modifying established products and in keeping to agreed production schedules. (Payment problems are less frequently complained of).

Managed Outsourcing
An alternative approach to outsourcing is to use a European-based intermediary to manage the process for you. There are several consultants experienced in manufacturing in China that offer such a service (sometimes known as 'managed outsourcing') to Western companies.

This service has several advantages compared with outsourcing direct or via a local import/export company:
• you are dealing with a Western intermediary, whose reputation can be assessed by reference to other clients for whom work has been performed.
• the contractual and payment aspects will usually be handled overseas, which is much more straightforward for a company new to China than dealing with Chinese entities direct.

Managed outsourcing consultants have offices in China through which they place, oversee and manage local production on their clients' behalf. The advantages of this method include:
• the ability to negotiate a low price by obtaining quotes from a number of competing sources
• maintaining control over quality throughout the production process
• and the assurance that the finished product will meet the client's standards

There is also a degree of inherent protection against intellectual property rights (IPR) abuse. Some of the managed outsourcing consultants offer the ability to undertake final assembly of a product under supervised conditions. This means that the components or sub-assemblies may be distributed amongst several Chinese manufacturers who do not have a view of the final product or even any notion of the purpose of the item they are manufacturing.

Choice of Investment Type
The habitual question amongst would-be investors is the type of enterprise they should seek: joint venture or wholly foreign-owned enterprise. There is no right answer. Experience suggests a widespread preference for a WFOE amongst UK investors in China in recent years.

Why choose a joint venture? What should you look for?
• An ideal partner who is honest, entrepreneurial, straightforward in its dealings
• committed to the protection of the joint venture company's IPR
• with good market access and local contacts
• and bringing with them a first-class workforce and facilities.

What are the problems with going the joint venture route?
(i) Lack of information about the prospective Chinese partner. A foreign company that locates a likely-looking company in China may have little knowledge of the company's background. In the past it has been hard to gain data about the commercial situation of Chinese companies or to substantiate their descriptions of themselves and their business relationships. This difficulty in carrying out checks to a rigour that would be usual in the West has sometimes meant foreign investors enter into JVs reluctantly, accepting the attendant risks.

However an increasing amount of advice is available nowadays, with UK- and China-based organisations (including CBBC) able to make checks on prospective partners. Some consultancies that specialise in this area offer comprehensive investigative services. Given the paucity of officially-filed business information in China, these processes may not amount to a full ‘due diligence' check; but such investigations can provide sufficient information to warn - or alternatively, reassure – would-be investors about many Chinese companies.

(ii) The need to retain comprehensive control. A frequently-cited reason why foreign investors are not attracted to the JV option is a wish to retain comprehensive control over their China production – something a WFOE can offer but not a JV. ]

What are the disadvantages of setting up a WFOE?
A disadvantage for an inexperienced investor setting up a WFOE in China is that much of the knowledge, administrative processes and contacts a partner would bring has to be gained the hard way. Strong relationships are a key factor for successful business in China, whether with the local authorities where the enterprise is located or along the supply chain.

Trading enterprises
Those companies who just want to trade with or retail in China, rather than investing, have their lives much easier following new laws introduced in June 2004. What these laws do is to "foreign-invested commercial enterprises" to import and sell goods without having to perform "significant processing" of the goods in China. This change is important because manufacturers investing in operations in China were permitted only to sell the output of their factories in China.

The easing of restrictions applies immediately to joint venture trading companies, and to trading WFOEs from 11th December 2004.

Entities involved wholly in trading and retailing will be permitted, with a registered capital requirement of RMB500,000 and RMB300,000 respectively.

Some commentators have concerns about how certain important details will be handled when the implementing regulations are published in full but it is generally agreed that the new laws represent a significant improvement for would-be investors in trading operations in China, including SMEs.